Question

Suppose a company simultaneously issues $50 million of convertible bonds with a coupon rate of 10% and $50 million of straight bonds with a coupon rate of 14%. Both bonds have the same maturity. Does the convertible issue's lower coupon rate suggest that it is less risky than the straight bond? Is the cost of capital lower on the convertible than on the straight bond? Explain

Answer 1

Answer:

1. No. The convertible bonds' lower coupon rate does not suggest that it is less risky than the straight or traditional bonds.  It is even riskier.  Mostly, companies that have reduced financial credit rating issue convertible bonds in the first place.  Secondly, converting into stock suggests that more risks will be tolerated with the hope of increased returns.

2. The cost of capital is lower on the convertibles than on the straight bonds because convertible bondholders will participate in sharing the profits left over by non-convertible bondholders, just like common stockholders when they convert to stock.  This participation in the retained profits is not available for straight bondholders.  This increased participation opportunity requires reduced fixed interest rates or cost of capital.

Explanation:

Convertible bonds are debt instruments that convert into common stock at the time determined by the holder but at the entity's specified price.  Straight (regular or traditional) bonds are not converted into common stock.  They only earn fixed interests from the entity and the return of the face value at maturity.